Building Wealth Through Rental Properties

A rental real estate investment can seem like a great way to build your wealth (and maybe generate a little extra income), but how often does it really work out that way?

Owning a rental property in addition to your primary residence can be a way for you to build wealth, especially if you may be averse to investing in the stock market. Data released in 2017 shows that 47% of rentals were owned by individual investors. In theory, it seems to make sense. With a rental property, someone else pays your mortgage, and over time your equity grows. You can eventually own a physical piece of property outright that also produces income. However, rental property investments aren’t always a sure thing.

Like any investment, you need to understand the expected return on investment (ROI). ROI = (Net Profit/Cost of Investment) x 100. Therefore, before you purchase a rental property, ask what return is reasonable to expect on your money, and what do you need to earn in order for the investment to be worthwhile?

Calculating the ROI of a rental property can be complex. While there are many different ways to do this, the point of this exercise is to provide you with a “back of the envelope” calculation to help you quickly assess whether or not a rental property has a return potential that is worth pursuing. If your calculation reveals that the return is small on paper, it’s likely going to be small in reality, too.

Before you can calculate the true ROI of a rental property, you have to factor in all the costs associated with holding that property, not just the purchase amount:

Revenue

Rental Income: How much you can charge for rent each month.

Mortgage paid down: How much of the property you own.

Change in property value: How much additional equity you have beyond the amount of the mortgage you have already paid down, based on current housing and rental market prices.

Expenses

Financing: If you didn’t buy the property with cash and took out a mortgage, the amount you pay per month in principal and interest.

Homeowner’s association dues: Fees you pay for community amenities.

Property insurance: The insurance you carry on your property.

Property taxes: What you pay in state and local taxes. And remember, property taxes don’t typically stay the same each year. They typically continue to rise unless an economic downturn allows you to have the property reassessed (typically for a fee) and re-adjusted downward.

Vacancy: The amount of cash you need to cover expenses when you don’t have a tenant. The standard vacancy rate is 5% to 8%, meaning that’s the percentage of the year that the property can be expected to sit empty.

Your time: The one item many people forget to account for is the cost of their own time. Whether it’s time spent as the handyman or finding a renter, your time is money, and anytime you put into managing the property reduces the return on your investment.

Rental properties can generate income, but the return on investment doesn’t typically happen right away. Rental property investments are also risky because of how many variables can affect its performance, like the housing market or your ability to keep it rented. So, if you are wondering if you should invest in real estate, really consider how appropriate this type of investment would be for you and your situation first.

As with any investment, rental properties should be viewed as a long-term investment, not an instant cash cow. If your goal is to grow wealth, I will tell you that there are other ways to generate a return on your income with less risk and headache, like investing in a globally diversified portfolio of stocks and bonds.

If you want to learn how to get started in rental property investments, contact us!

Disclaimer: The information in this blog has been prepared solely for informational purposes. The contents are based upon or derived from information generally believed to be reliable although Visio Lending accepts no liability with regard to the user's reliance on it. For legal advice, please contact your counsel.

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